What is a Roth IRA?

By John Azoddi

Azodi CPA & Investment


What is a Roth IRA? Simply put, with a Roth IRA you contribute money on which you do pay income tax; in other words, it is after-tax money that you invest. Once you set up this account and contribute this money, it grows tax-deferred as long it remains in a Roth IRA. Once you are older than 59½ and have had the Roth IRA for at least five years, then the earnings becomes tax-free and it is called a "qualified Roth IRA." But if you take the Roth IRA out before age 59 ½, even after holding it for more than five years, it is taxable and subject to penalty. Also, if you started the Roth IRA after you turn 59 1/2, in order for the earning to be tax free, you must hold it for at least five years or more. After a Roth IRA becomes a qualified Roth IRA, the total distribution is tax-free, since you have paid the tax on the original investment.

There are two ways to set up a Roth IRA. The first one is called a contributory (or regular) Roth IRA. The second is a Roth IRA conversion.

The contributory Roth IRA is the most common way to fund to a Roth IRA; therefore, it is common for people to say Roth IRA without referring to the contributory portion of the name. This is how you contribute if you are working and earning money, either as an employee or working for yourself (or as a working partner in a partnership), or if you are receiving alimony. The earnings from self-employment and wages are called earned income, whereas interest, dividend, and rental income are called passive income. In order to start a Roth IRA, you must have earned income. You can put money into the Roth IRA up to the limit the IRS allows on the amount you have earned. For instance, if you and your spouse together had $15,000 in earned income in 2009 or 2010 and you are 50 years old or older, you can set up a $6,000 Roth IRA for each of you, even if only one of you earned the $15,000. If your earned income is less than $12,000, for example, $7,000, you can set up a Roth IRA for the total of $7,000. That could be any combination, such as $3,500 for each of you, or $6,000 for one of you and $1,000 for the other.

There is no age limit for starting or continuing contributions to the Roth IRA as long as you have earned income. At age 70½, however, you are no longer able to contribute to a regular IRA. So, people over age 70½ who do have earned income should consider starting or continuing with their Roth IRA. The limits for a person over age 50 (any day in the tax year) are higher due to the allowance of additional contributions called "catch-up contributions." Therefore, if you turn 50 on December 31, 2010, you can use the higher limit amount for the year.

The ability to contribute to a Roth IRA is eliminated for the high-income earner. According to the IRS (for 2010), you are considered a high-income earner if you make more than $120,000 annually if single, and more than $177,000 if married. The IRS changes the limits for inflation each year.

If single, your contribution of $5,000 (or $6,000 if 50 years old or older) will be reduced as your income increases from $105,000 to $120,000 (for 2010). Once your income is more than $120,000, you are not eligible for a Roth IRA. If married, your contribution of $5,000 (or $6,000 if 50 years old or older) will be reduced as your income increases from $167,000 to $177,000 (for 2010). Once your income is more than $177,000 you are not eligible for a Roth IRA.

For married persons filing separately, the rules are different depending on whether you are living with your spouse or not. If you are married but lived apart from your spouse during the entire year, then the rule for single applies (see above). However, if you are married and lived with your spouse even one day, then the phase out is from zero to $10,000. That means that if your income is more than $10,000 per year, you are not eligible to contribute to a Roth IRA. The IRS implemented this stipulation to prevent married people who do not qualify (as above) from filing separately (when one has little income) to manipulate the rules.

The second way to have a Roth IRA is to have a Roth IRA Conversion. This is for those people who already have an IRA. You can convert all or part of your IRA to a Roth IRA; however, by doing so, you are required to pay tax on the amount that is converted.

Once converted, it acts like a regular Roth IRA with the same features described in the previous chapters. If you consider doing a Roth IRA conversion, the conversion must be complete before December 31. The tax is due in the year the conversion is completed. To qualify for the conversion for 2009, your adjusted gross income (AGI), without counting the Roth IRA conversion and RMD from a regular IRA if you are over 70½, has to be less than $100,000. Your AGI is the total of all income less certain adjustments. It is shown on the last line (37) of page one of your Form 1040 tax return. Alternatively, it is on line 21 of page one of Form 1040A.

However, the IRS is allowing everyone to convert his or her IRA into a Roth IRA in the year 2010 without the AGI limit. The best part is that you have two years to pay the tax on this conversion.

What happens if you convert your IRA into a Roth IRA and when you are preparing your income taxes you realize it is costing you too much in tax or you went over the $100,000 adjusted gross income limit? The IRS allows you to reverse the conversion without any tax consequences once per calendar year before the due date of your tax return, plus the maximum six-month extension period (whether or not the return is actually extended). This is called a Roth IRA recharacterization. For example, the deadline to recharacterize a 2010 Roth conversion is October 15, 2011.

By converting, you will be reducing your IRAs, which means, after you turn age 70½, your required minimum distribution would be less.

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